Turning Homes into Winning Assets

JONAS P. LEE OWNS A CO-OP APARTMENT in New York's Murray Hill section, which he shares with his wife and 2-year-old son.

But the 38-year-old investor sees much better home values in the solid working-class neighborhoods in places like Philadelphia, Baltimore, Trenton and Stamford, Conn.

In the past three years, Lee, a former Internet entrepreneur and Harvard Business School graduate, has been buying up hundreds of homes on behalf of Redbrick Partners.

Redbrick may be the only private real-estate limited partnership in the U.S. devoted exclusively to investing in single-family homes. (Such partnerships exist in Europe.)

"We either have no competitors right now, or we have millions of competitors, depending on how you look at it,'' says Lee.

Right now, Redbrick's two private funds are closed to new investors, and he isn't disclosing plans for any new funds.

But Lee continues to buy houses for his current two funds for prices ranging from $50,000 to $120,000. He likes homes in neighborhoods that are on the upswing, thanks to solid local economies and low crime rates.

Lee generally buys homes from individuals or smaller private investors and then hires local property managers to fix them up, maintain them and collect the rents.

So far, the $10.2 million-asset Redbrick Partners Fund, the older of the two funds he is operating, generated a return of 52% after fees last year, according to Lee. Of that, a quarter was from net rental income, a quarter was from realized gains from the sale of some units, and about half was from unrealized gains in property values. (Another larger fund, Redbrick Partners II, hasn't been in operation for a full year yet.)

Recently, Barron's Online talked with Lee about the ins and outs of buying homes by the hundreds.

Barron's Online:If creating a fund that invests in a portfolio of hundreds of houses is such a good idea, why are you the only ones doing it in this country?Lee: That is a question we spent about a year trying to figure out. If Americans are basically doing well investing in their own homes, we asked: Why isn't there a fund that can just diversify that risk and have professionals take care of it? The next logical thought was: Well, if it doesn't exist, maybe it shouldn't exist. And so we hooked up with some economists at Yale and MIT and spent a good period of time doing the research on the returns and volatility over time. The net result is that it is actually an amazing asset class to invest in. When I started interviewing a lot of the commercial real-estate investors about buying houses as an investment class, the general response was basically: "Sounds like a lot of work. Good luck kid." Unlike buying an apartment building or office building, you can't put 50 million or more to work in one deal when you're buying houses. In putting together a portfolio of houses, you have to build it like a business as opposed to a series of deals.

Q:What do you want to see with rental yields? A: We look at rental yields of 8% plus. (Editor's Note: A rental yield is defined as yearly rental income less operating costs divided by the market value of the home.)

Q:What kind of price appreciation have you seen in the homes in working-class neighborhoods that you buy compared to the national average? A: In the working-class neighborhoods in which we are investing in, housing prices went up 13% for 2004, according to federal housing reports. Nationwide, the rate has been 11%.

Q:Why are all of your properties in the Northeast and Mid-Atlantic states? A: These are the regions economists like best, with the right combination of market appreciation and rental yields of 8% or more. Out in California, you would be hard pressed to get a yield like that.

Q:What about working-class neighborhoods in places like Ohio or North Carolina? A: We don't want to expand too quickly, too far. But we do think places in Ohio might be interesting -- that's a very stable state. Over the next 10 years, we hope to have operations nationally. And we have plans to extend into San Juan, Puerto Rico.

Q:Describe the ideal neighborhood your fund likes to invest in? A: These are neighborhoods where people have jobs, but about 50% to 60% of the homes are for rentals versus owner-occupied. As an investor, you don't want to be in just a purely rental community &ndash; that's too low-income &ndash; and you don't want to be a community that's almost 100 percent owner-occupied. We're also looking at neighborhoods that are undergoing positive change, such as an improvement in local employment or reduced crime. So it can be a tough neighborhood as long as it's on the upswing. For example, Albany is not a market we like, but Trenton is a market we like very much.

Q:What kind of investors have brought into your funds so far? A: It's mostly high net-worth individuals who don't have three committees to go through before they can make an investment decision. But as we develop a track record, that is starting to shift. The longer you are in business the more palatable we will be to institutions who can make larger investments.

Q:Is it wise for investors, who presumably own their own homes, to take on an additional investment in a basket of other homes? Shouldn't a homeowner be turning to other asset classes, out of a need to diversify? A: No. Because owning a luxury home in a place like Manhattan or Greenwich, Connecticut is a different asset class than the working-class communities we are investing in. In fact, those high-priced luxury neighborhoods, where our investors live, are overpriced right now and not the best investments. So if you are living in those areas, I would say that it's a more viable strategy -- from a portfolio allocation standpoint -- to sell your house because you can usually get a very good deal renting a property in a good neighborhood. Then you should allocate that remaining capital (from the sale of a home) in a fund that invests in very high cash flow and good appreciating markets in working-class neighborhoods. Now would anyone listen to that advice? No. That's because owning your home is an emotional decision, not just a financial one. But if you are just looking at the numbers, that's exactly what you should do.

Q:There has been so much talk about a bubble in housing prices based on irrational buying. Are you concerned about a bubble in the U.S., and specifically in the neighborhoods that you are investing? A: I would be worried about a bubble in certain neighborhoods, if I lived there myself right now. There are a lot of reasons to be worried about places like Boston, San Francisco, L.A. and Miami, and probably Fort Lauderdale too. However, in these working-class neighborhoods that we are invested in, it is really hard to see any kind of bubble because people aren't buying houses for speculative reasons. People are buying because they can rent them at a certain cash flow metric, or they can live in them because they have a job in the area. In Miami, for example, people are buying condos to flip because they can make a lot of money by holding on to it for 6 months and then selling. That is a sign that the music could stop, and you might be held left holding the bag.

Q:Are you still buying homes in this environment as aggressively as you were, say a year ago? A: More aggressively, actually. And we are hoping to put about $150 million to work in properties over the next 18 months, and that's a lot of $60,000 to $80,000 homes.

Q:What's your advice to the average American who is thinking about buying and possibly rehabbing a house or two purely as an investment? A: I think even if you have no idea what you are doing, it seems kind of hard to lose over the next year. Almost all markets are showing so much momentum that it is going to be really hard to lose. Now what happens a year from now, I will have to re-evaluate. In general, many people buy homes without having done their homework. They haven't really figured out what kind of rental yield they might be stuck with, if they can't sell it for what they want to sell it for. They haven't really gone through what are the insurance costs or what their renovation costs might be. For sure, if the market goes up 11% in one year and you put down 20% as a down payment, it's kind of hard to screw it up. But when the market changes, as it must, in the next few years, it is going to be very difficult for a lot of people to make their money back. I think you will find a lot of people that were budding entrepreneurs in the rehab business will be looking for something else to do.

In managing two Redbrick Partners private funds, Lee invests in houses in working-class neighborhoods that have solid economies and low crime rates. He focuses on homes that can generate yearly rental income (net of operating costs) that is 8% or more of the market value of the homes. The homes tend to sell for $50,000 to $120,000.

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